How to Be a Contrarian While Managing the Currency Risk

What has been one of the most important drivers of the negative total return within emerging market (EM) investment strategies in 2015? The answer: currency. For the first three quarters of 2015, emerging market currencies have depreciated compared to the U.S. dollar—some much more significantly than others. At the worst end of the spectrum, the Brazilian real lost approximately one-third of its value measured against the U.S. dollar, and on the other end of the spectrum, the Chinese yuan—a currency often remarked upon for the lack of a market-determined exchange rate—even lost a few percentage points of its value against the dollar.1

Taking the Brazil example: Using one-month forward contracts to initiate a hedge of the Brazilian real versus the U.S. dollar, there is a 13% difference in short-term interest rates between Brazil and the United States, and that is the cost to hedge the real versus the U.S. dollar.3

One of the notable contrarian investments today would be emerging markets, as performance has been challenged. But there is good news: Not all EM investments have as much currency risk.

While the emerging market sovereign bond market is moving more and more toward debt issued in local currency, thereby better matching government revenues with government liabilities, the large majority of emerging market corporates issue debt denominated in U.S. dollars. This means that an investor can gain exposure to emerging market corporate credit without needing to have exposure to the performance of emerging market currencies against the U.S. dollar.

Note, unlike many of the sovereign countries that issue their debt in U.S. dollars and earn revenue solely in their local currencies– leading to a different and often hidden currency risk due to the debt being owed to lenders in U.S. dollars—many emerging market corporations, especially commodity-centric ones, also earn their revenue in U.S. dollars. These emerging market corporations therefore have a better asset and liability matching than the countries issuing debt in U.S. dollars.

WisdomTree has partnered with Western Asset Management Company in just such a strategy—the WisdomTree Emerging Markets Corporate Bond Fund (EMCB)—since March 2012. Given that currency has been a major headwind in emerging markets during the first three quarters of 2015, we show how EMCB performed compared to other emerging market assets, knowing that it avoided the currency impact. We also looked at the third quarter of 2015 performance, as this quarter was marked by significant volatility.

Average Annual Returns as of September 30, 2015

EMCB Outperformers over Year-to-Date & the Third Quarter of 2015

• EMCB as Least Negative: While neutralizing the currency headwind to returns did improve the picture, it was still not quite enough for a positive return. However, this shows just how important it is to think carefully about different emerging market options. We think that pairing an investment vehicle like EMCB with other emerging market investments that may have currency exposure could offer an interesting strategy.

• CEW Provides a Diversified Metric for Emerging Market Currency Performance: CEW represents a basket of 15 emerging market currencies, all rebalanced back to an equally weighted 6.67% each quarter. Its performance, at least in part, provides an interesting window into how emerging market currencies, broadly, are faring against the U.S. dollar. The one caveat to this is that, as of September 30, 2015, embedded income yield of these positions was in the neighborhood of 5.5%, and this would provide a cushion to any decline in the spot prices of the represented currencies against the U.S. dollar. (See current standardized yield information for CEW). XSOE, DGS, DGRE, DEM and EMCG—exchange-traded funds designed to track the performance of equity indexes4 —do not have exposure to this cushion. It’s also worth noting that it is precisely this cushion that makes hedging these currencies with forward contracts more expensive.

Implementing an Emerging Market Strategy in the Fourth Quarter of 2015

While we believe that emerging market asset classes may be getting to a point where the negative performance and present valuations may appropriately reflect the inherent risks, it still does not make allocating there easy—especially with things like the U.S. Federal Reserve interest rate decision, China’s economic growth picture and a commodity price recovery all being open questions. Investors often use bonds in the U.S. to mitigate the volatility of equities. This strategy could work very well for those who want to increase their exposure to the emerging market asset class.

Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. Funds focusing on a single sector, region and/or smaller companies generally experience greater price volatility. Investments in emerging, offshore or frontier markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments. Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations. Derivative investments can be volatile, and these investments may be less liquid than other securities, and more sensitive to the effects of varied economic conditions. Certain Funds may invest in the securities included in, or representative of, their Indexes, regardless of their investment merit, and those Funds do not attempt to outperform their Indexes or take defensive positions in declining markets.

Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. In addition, when interest rates fall, income may decline. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. Some Funds can have a high concentration in some issuers, and those Funds can be adversely impacted by changes affecting such issuers. Unlike typical exchange-traded funds, there is no index that the Funds attempt to track or replicate. Thus, the ability of the Funds to achieve their objectives will depend on the effectiveness of the portfolio manager. Due to the investment strategy of certain Funds, they may make higher capital gain distributions than other ETFs. Please read each Fund’s prospectus for specific details regarding each Fund’s risk profile.

Investments in commodities may be affected by overall market movements, changes in interest rates and other factors such as weather, disease, embargoes and international economic and political developments. Hedging can help returns when a foreign currency depreciates against the U.S. dollar, but can hurt when the foreign currency appreciates against the U.S. dollar.

– See more at: http://www.wisdomtree.com/blog/index.php/how-to-be-a-contrarian-while-managing-the-currency-risk/#sthash.rM93fRhJ.dpuf

Author: WisdomTreeAbout WisdomTree
WisdomTree launched its first ETFs in June of 2006, and is currently the industry's fifth largest ETF provider. WisdomTree sponsors 69 distinct ETFs that span asset classes and countries around the world. Categories include: U.S. and International Equity, Currency, Fixed Income and Alternatives. WisdomTree pioneered the concept of fundamentally weighted ETFs and active ETFs and is currently an industry leader in both categories. WisdomTree is the only publicly traded asset manager exclusively focused on the ETF industry.WisdomTree is listed on the NASDAQ Global Market under the ticker: WETF.